Yves Smith: Preventing the Next Financial Crisis by Reforming Wall Street Pay

Yves Smith leads those of us who want Silicon-Valley compensation schemes for Wall Street:>naked capitalism: Obama Administration Considering Tackling Financial Services Pay: Before anyone gets hysterical, the focus of the efforts by Team Obama on financial services industry pay appears to be to force the industry to stop rewarding undue risk taking. As much as I have been critical of many Administration plans, this, at least in concept, is a good one. Why? Because I sincerely doubt Team Obama will do more than set guidelines and principles. and that may not even prove necessary if they show enough resolve. If the industry wasn’t so predictably out to keep all its perquisites despite its horrific performance, this sort of effort would not be necessary. We’ve had some fulminating by Goldman CEO Lloyd Blankfein, plus an earlier line of thought in a Financial Times comment mainly on the failings of risk management:>>More generally, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.>This would take the firms a fair bit of the way back to the old partnership model. Funny how they were more careful about risk when it was their own capital on the line. But the exposure in those days was even greater, since the partners are personally liable. LTCM managed to blow itself up even though its principals have almost all of their money invested it. Yes, this would be a huge step in the right direction, but I wonder if any model that involves limited liability, other people’s money, and a government backstop (which we now know is guaranteed for big players) is still a troublesome mix. But fine sentiments are no substitute for action, and there seems to have been perilously little, save UBS’s malus plan, in which much of the bonus is put in escrow and may be reduced if some of the recipient’s actions are found to have been damaging to the bank.>The problem with any action on the bonus structure front is that it needs to be reasonably broad based. One firm acting alone, save perhaps Goldman, is likely to expose itself to defections if its program is too far out of line with industry norms. Thus if the industry has any sense, Team Obama’s pressure will presumably elicit responses from the industry. Note that some of the ideas being bandied about apply to traditional lenders, such as banning rewards based on meeting volume targets, which creates incentives to ignore loan quality. From the Wall Street Journal:>>The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry, including at companies that did not receive federal bailout money, according to people familiar with the matter. The initiative, which is in its early stages, is part of an ambitious and likely controversial effort to broadly address the way financial companies pay employees and executives, including an attempt to more closely align pay with long-term performance…. Among ideas being discussed are Fed rules that would curb banks’ ability to pay employees in a way that would threaten the “safety and soundness” of the bank — such as paying loan officers for the volume of business they do, not the quality. The administration is also discussing issuing “best practices” to guide firms in structuring pay. At the same time, House Financial Services Committee Chairman Barney Frank (D., Mass.) is working on legislation that could strengthen the government’s ability both to monitor compensation and to curb incentives that threaten a company’s viability or pose a systemic risk to the economy…. But any legislation passed would make it harder for policy makers to dial back limits once the financial crisis subsides…>Yves here. Please. That last sentence is editorializing. How many rules and laws went unenforced in the last cycle? And if bad incentives lead banks to take risks that pose a danger to the system, which they have, trying to influence their practices is not a bad concept. Have we forgotten that banks run off the cliff like lemmings at least every ten years? The bigger point is that banks are subject to taxpayer backstops. That puts them in a very different category than most businesses. Since the banks have abused their access to the public till, more intrusive policies are called for. Back to the article:>>Regulators have long had the power to sanction a bank for excessive pay structures, but have rarely used it…. Government officials said their effort, which is just beginning, isn’t aimed at setting pay or establishing detailed rules. “This is not going to be about capping compensation or micro-management,” said an administration official. “It will be about understanding what is the best way to align compensation with sound risk management and long-term value creation.” Despite the banking industry’s weakened state, it would likely try to push back against curbs on how financial firms can compensate people. Bank executives have complained to federal officials that strict rules could prompt some of their best employees to move to parts of the financial industry that aren’t regulated, such as hedge funds, private-equity firms and foreign banks. They’ve also argued that paying substantial bonuses is integral to how the industry works….>>During a recent congressional hearing, Chairman Ben Bernanke said the Fed was working on rules that will “ask or tell banks to structure their compensation, not just at the very top level but down much further, in a way that is consistent with safety and soundness — which means that payments, bonuses and so on should be tied to performance and should not induce excessive risk.” In an indication of how broad the effort may become, Federal Deposit Insurance Corp. Chairman Sheila Bair said regulators need to examine compensation practices in the mortgage industry, suggesting new limits could stretch beyond banks…

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